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Crowdsourcing Loans: Investing Without the Bureaucracy

Maybe you're disillusioned by big banks, or wish you could grow your portfolio without buying in to what sometimes feels like a corrupt institution. Then again, maybe you're attracted to the idea of investing and helping another human being at the same time.

That’s the dream behind the new trend of peer-to-peer lending. Here's how it works, and why current economic trends are making it possible--and popular--now.

Current problem for investors: Because interest rates are low, the returns you’ll make on a bond are also pretty low compared to past years. Low interest rates also mean low returns on your investments in a savings account or CD.

Current problem for borrowers: Credit has gotten harder to come by since the recession, and more and more people distrust big banks. If only there were some other way to get a loan … Websites like Prosper and LendingClub let investors lend money to regular people, who pay relatively affordable interest rates, which the investors receive as returns.

In many ways, it’s the same basic model as a traditional bond investment … minus traditional brokerages or banks. Prosper boasts rates starting at 6.59% APR for borrowers, and an average of about 10% returns for investors. LendingClub starts the borrowing at 6.78% APR and touts net annualized returns for investors of 5.8% to 9.59%. Considering that returns on a 1-year CD are hovering around 0.75%, that sure soundslike a good deal.

But Here’s the Rub …

Like a traditional investment in a bond, these sites give their borrowers a credit rating—in other words, how likely they are to pay back the loan. The higher the risk that the borrower will shaft you, the higher the returns you receive. (In much the same way, if you’re deemed “higher risk,” you’ll have to pay more to borrow.)

But as Stephany Kirkpatrick, LearnVest's Director of Financial Planning and Certified Financial Planner, puts it: “These are highly risky investment vehicles and are very, very new. This amount of risk is not appropriate for most everyday investors. I would say, steer clear unless you are a higher-net-worth individual with a high degree of risk tolerance.”

Lending money to individual borrowers comes with a lot more risk than traditional bonds, which usually involve lending to a company or government. And, though you’re probably doing a good deed if you’re lending your money to someone in the process of consolidating her credit card debt—which accounts for about 70% of the loans on LendingClub—you might have your risk cut out for you.

Plus, LearnVest always encourages you to diversify your portfolio. In other words, you shouldn't put all your eggs in one metaphorical basket. Investments like mutual funds enable you to invest in many things at once, whereas these peer-to-peer investments are much narrower in focus.

LearnVest Certified Financial Planner (CFP®) Sophia Bera adds, “These types of investments tend to carry a lot more risk than traditional bonds. People should not risk any of their retirement money with this type of alternative investment.”

In other words, we can’t speak to whether you’d find these investments to be amazingly awesome or amazingly terrible, but we can speak to the fact that socking away money for retirement is absolutely crucial (here are the basics), and we don’t want to see you jump on a trend that ends up hurting your future.

Editor's note: Stephany Kirkpatrick's original quote stated that these peer-to-peer resources are not registered investment vehicles; we have amended this quote, as some, like LendingClub, are registered with the SEC. Since some peer-to-peer lending companies may not be registered investment vehicles, if you are planning to invest in this new way, be sure to check the prospectus to verify whether the company in question is accredited.

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LearnVest Planning Services is a registered investment adviser and subsidiary of LearnVest, Inc. that provides financial plans for its clients. Information shown is for illustrative purposes only and is not intended as investment advice. Please consult a financial adviser for advice specific to your financial situation. LearnVest Planning Services and any third-parties listed, discussed, identified or otherwise appearing herein are separate and unaffiliated and are not responsible for each other’s products, services or policies. LearnVest, Inc. is wholly owned by NM Planning, LLC, a subsidiary of The Northwestern Mutual Life Insurance Company.